What should I do when the stock price drops?

What should I do when the stock price drops by 30%?

Knowledge is a very powerful tool. Investing requires knowledge and familiarity of the companies that you choose to plough your hard earned money into. This may be a good reason not to own too many stocks but invest within your circle of competence. You need to have a diversified portfolio but not beyond what you can handle.  For instance, I am visiting Breadtalk during breakfast, lunch and dinner to observe the crowd, the service level and menu. I will try to understand the price level and when they will increase price and give promotions to drive sales. You need to understand the companies you want to invest in thoroughly and its external factors such as competition and macro factors.

Know nothing about the company

I was having this chat with my mum this morning and questioned her why she bought InnoPac. I glanced through the Annual Report which was mailed to the house and immediately threw it aside. My mum explained back then there was a bull run and every single stocks had increased two to three folds and only this stock was like a few cents. Then they put their money into it and never see it grow past their initial investment. When I asked her what does the company do? What was the business behind the company? She just shrugged. Cheap does not mean the stock is good. My friend's girlfriend asked me whether she should buy penny stocks. I said," Unless you know the companies well, please don't throw away your money and buy ETF instead." As she is not into trading but want to invest thinking penny stocks are less pricey and can buy more of it with her monthly saving. I was burnt in the past with penny stocks and one of them was de-listed. It is in my portfolio to serve as a gentle reminder.

When the stock price is going up is not good enough reason to own the stock and keep it in the portfolio. Likewise, when the stock price is going down is not a reason to sell as well. In the short run, the market is a voting machine and in the long run, the market is a weighing machine. Firstly, you need to understand the business of the stock that you own.

Determine whether it is a good company

The company's success is related to the stock's price. It is imperative to focus on the long term and look at future earnings instead of historical earnings. You need to understand that profitable companies in today context may be future losers because new competitors will come into the market and erode their margin. Do you still remember Nokia handphone? It used to be very profitable until the smart phones came along. Apple replaced Nokia and dominate the market for a few good years. Apart from the business, you need to question what is the competitive advantage the company has over the competitors and whether the economic moat is deep and wide enough to fend off other competitors. With all these in mind, you just need to be patient and wait for the price to drop until it reaches a level with sufficient margin of safety. Then you just need to buy more of the company's shares. Margin of safety is important to protect you from unforeseen factors which blindsided your judgement.

Volatility in the market

Volatility is good for the market. After the meeting in Doha failed, the share price dropped and the very next day, the share price recovered. Stock market price movements are nothing to be concerned about. You should be happy when there is volatility in the market, especially when the stock price drops. Mr Market is presenting a discount to the price and it is a great opportunity to snap up this bargain.

Warren Buffett said: “Price fluctuations are there to provide opportunities to buy wisely when prices fall sharply. At other times you would do better to forget the market and pay attention to the operating results of companies."

You should not focus on the price but focus on the fundamental of the business. You should only sell the stock not when the price drops by 30% but when the company's business has deteriorated and it is an irreversible situation. You need to remember that you are a long term investor and not a short term trader. Seat back and collect dividend!

Cash Flow Statement

The Statement of Cash Flows

This statement shows the value created by the company based on how much cash generated year to year. This is the most important section of the financial statements. The cash flow statement strips away all the abstract, non cash items such as depreciation which you see on income statement and tells you how much actual cash the company has generated. The cash flow statement is divided into three portions: cash flows from operating activities, from investing activities and from financing activities.

1st Section - Cash flows from operating activities

Cash Flow from Operating Activities tells you how much cash the company generated from its business. This is the area to focus your attention on the cash generating power of business that we are most interested in.

Depreciation and Amortization

This is not a cash charge. So we need to add this back to net income.

Changes in Working Capital

If a company is owed more money by customers this year than it was last year, accounts receivable increase and cash flow decreases, if it owes more money to suppliers, accounts payable increase and so does cash flow. Finally if a firm pumps more money into inventory that does not sell, cash flow decreases. Inventory ties up capital.

One-Time Charges

This need to be added back when figuring cash flow (similar to depreciation, which is also noncash).

Net Cash Provided by Operating Activities

This is also known as operating cash flow, it is the result of adding or subtracting the previous items from net income. It doesn't replace net income but if you don't look at it in addition to net income, you are not getting the full picture.

2nd Section - Cash Flow from Investing Activities

This section involves acquiring or disposing PP&E, corporate acquisitions and any sales or purchases of investments.

Capital Expenditures

This figure represents money spent on items that last a long time such as PP&E, basically anything needed to keep the business running and growing at its current rate. Operating cash flow minus capital expenditures equals free cash flow, or the amount of cash the company generates after investing in its business.

Investments Proceeds

Companies often take some of their excess cash and invest it in bonds or stocks in an effort to get a better return than basic saving account. This number tells us how much money the company has made or lost on such investments.

Final Section - Cash Flow from Financing Activities

Financing activities include any transactions with the company's owners or creditors.

Dividends Paid

This is the money spent on dividend.

Issuance/Purchase of Common Stock

This is important number to look because it indicates how a company is financing its activities. Rapidly growing companies often issue large amount of new stocks which can dilute the value of existing shares but gives cash for expansion. Slower but more mature companies that generate a lot of free cash flow tend to buy back significant amounts of own stocks though companies that issue many stock options to their employees also buy back stock to minimize dilution. You need to be wary of companies that grant their employees with options and then spend corporate cash on repurchases are essentially selling shares to their employees at low prices and buying it back on the open market at much higher prices at the expense of shareholders.

Issuance/Repayments of Debt

This number tells you whether the company has borrowed money or repaid money it previously borrowed.

Income Statement

The Income Statement

The Income Statement explains how much money the company is making or losing.

Revenue

Revenue also known as sales is how much money the company has brought in during a quarter or a year. Larger companies sometimes break down revenues on the income statement according to business sector, geographic region or products versus services. You will need to understand how revenue is been recognized in the financial statements, companies can record revenues at different times depending on business they are in.

Cost of Sales

Otherwise known as Cost of Goods Sold, represents the expense involved in creating revenue such as labor costs, raw materials or whole price of goods. Large companies combine manufacturing with services sometimes break down this number into cost of goods sold and cost of services.

Gross Profit

It is not a number on Income Statement but can be derived by revenue minus cost of sales. Once you have gross profit, you can calculate gross margin which is gross profit as a percentage of revenue. A more differentiated product or services will have a higher gross margin than its competitors.

Selling, General, and Administrative Expenses (SG&A)

This is known as operating expenses which includes items such as marketing, administrative salaries and research & development. If you see a forecast in decrease in SG&A, the company may be reducing headcounts. To analyse efficiency of a firm, you can look at SG&A as a percentage of revenues, a lower percentage of operating expenses relative to sales mean a tighter and cost effectiveness. You need to compare the company with the nearest competitors.

Depreciation and Amortization

When a company buys an asset intended to last a long time, such as a new building or a piece of machinery, it charges a portion of the cost of that asset on its income statement over a series of years. It is always included in the cash flow statement, you can look there to see how much a company's net income was affected by non-cash charges such as depreciation.

Nonrecurring Charges/Gains

This is the area where companies put all one time charges or gains that is not the norm such as cost of closing a factory or gain from selling a business. It is preferred not to have this section in the Income Statement.

Operating Income

This number is equal to revenue minus cost of sales and all operating expenses. It represents the profit the company made from its actual operations, as opposed to interest income and one-time gains. Companies often include nonrecurring expenses in figuring operating income, and you have to add back one-time charges. Operating income excludes one time items as well as income from non-operational sources such as investments, you can use it calculate operating margin which is  comparable across companies and industries.

Interest Income/ Expense

Sometimes Interest Income and Interest Expense are listed separately and sometimes they are combined into net interest income. In either case, this number represents interest the company has paid on bonds it has issued or received on bonds or cash that it owns. You can get some insight into the financial health of a firm by looking at its earnings before interest and taxes relative to its interest expense which is called an interest coverage ratio.

Net Income

This number represents company's profit after all expenses have been paid and it is the number most companies highlight in quarterly earnings. Net income can be distorted by one-time charges and investment income.

Number of Shares (Basic and Diluted)

This figure is the number of shares used in calculating earnings per share, it represents the average number of shares outstanding during the reporting period. Basic shares include only actual shares of the stock. Diluted shares include securities that could potentially be converted into shares of stock such as stock options and convertible bonds. Given the amount of granting of stock options that occurred over past years, it is the diluted number that you will want to look at because you want to know the degree to which your stake in the firm could potentially be shrunk or diluted if all those option holders converted their options into shares.

Earnings per Share (Basic and Diluted)

This number represents net income divided by number of shares. You need to look at cash flow and many other factors when considering EPS. This number does not represent all of the corporate financial performance.

Balance Sheet

The Balance Sheet

The balance sheet tells you how much a company owns in its assets, how much it owes in its liabilities, and the difference will be equity. Equity represents the value of money the shareholders have pumped into the company.

Assets - Liabilities = Equity

Current Assets

Current Assets are used up or converted into cash within one business cycle which is usually one year. The major portions of this category are cash and equivalents, short term investment, accounts receivables and inventories. Cash and equivalents and short term investments refer to items which can be liquidated quickly into cash. Short term investments is similar to cash such as bond with less than a year to maturity and earn a higher rate of return than cash.

Accounts Receivables are bills that the company has not collected but expects to be paid soon. If accounts receivables rise faster than sales, the firm is trying to get sales but relaxing its payment terms. When you see an "Allowance for Bad Debts" is the company's estimate of how much money is owed by customers which is unlikely to be paid.

Inventories include raw materials which has not been made into finished product. Inventories are important to monitor for manufacturing and retail companies. Inventories require cash which will deprive the company from other opportunities to make profit. The less time cash is tied to inventory will have a larger impact on profitability.

Non-current Assets

Noncurrent assets are assets that are not expected to be converted into cash or consumed within reporting period. This section consist of property, plant and equipment (PP&E), investments and intangible assets. Property, plant and equipment are long term assets which consist of land, buildings, factories, furniture, equipment and machinery. Investments is money invested into long term bonds or other companies. Intangible assets consist of goodwill which is accounted for when one company acquires another.  Goodwill is the difference between the price the acquiring company pays and tangible value of the target company. Goodwill is the area to scrutinize, very often company overpay their target acquisition.

Current Liabilities

Current liabilities are money the company expects to pay out within a year. You should focus on accounts payable and short-term borrowings/payables.

Accounts Payable are bills the company owes to somebody else and are due to be paid within a year. Large companies can delay paying their subcontractors or suppliers which means holding on to their cash longer which is better for cash flow management. Short-Term borrowings/ payables refers to money the company has borrowed for a term of less than a year to meet short term requirement. This can lead to financial crisis if the company does not have sufficient cash or means to refinance.

Non-current Liabilities

Noncurrent liabilities are money the company owes one year or more in the future. The key is long term debt which represents money the company has borrowed by issuing bonds or from bank which does not need to pay back for a few years.

Shareholders' Equity

The only account worth looking at is retained earnings which basically records the amount of capital a company has generated over its lifetime minus dividend and stock buybacks. Retained earnings is a cumulative account, each year when the company makes money and does not pay it all out as dividends, retained earnings increase. If company loses money over time, retained earnings can turn negative and become "accumulated deficit".

Annual Reports

Reading Annual Reports

A company's financial reports are akin to a medical report of a person, it will display the health status. The financial reports consist a lot information which involved the management team and financial statements. Financial reports help the investor to make the decision whether the company is still worthwhile to invest in or it is time to take flight.

Potential investors of a company can download the annual report from SGX website or company website's investor relations page. The annual report is released after financial year and there will be quarterly interim reports for investors to monitor the business.

The corporate profile shows the business the company is involved in, it will describe the various business segment and business outlook. The financial highlights will provide a summary of the key financial metrics on revenue, profit and dividend payouts. This will show to investors how well the company has performed over the past few years.

On Chairman's statement, it will be prudent to read through past years statements to see whether there is a consist message on the business plans. If the company mention that they are doing a turnaround strategy then you can understand the actions taken and whether it is on track or some how it has been derailed. A change of tone will show whether the business has became more optimistic or pessimistic.

We will focus on the financial statements in the next post as this is the crux of the annual report. The three main sections consist of Consolidated Income Statement, Balance Sheets and Consolidated Statement of Cash Flows. It is important to look at the notes below each page of the financial statements. They show detailed explanations on how the figures are derived and assumptions made during the compilations.

In conclusion, when you download the annual reports of interested or invested company in the future, do spend time to decipher the documents. There are a trove of treasures hidden in each annual report.

Prudent Investing

Do you buy stocks based on what your friends, relatives or stock analysts recommend? Prudent investing is a mindset and philosophy of investors. Successful investing is accumulation of shares in a good business. The business grows or deteriorate on a daily basis but the share price tickers will fluctuate on a daily basis more than the actual business condition. This is what Ben Graham coined as Mr Market will visit day in day out and present a different price to the investors. Mr Market can be rationale on certain days and behave irrationally on other days.

You need to weave this together with the mindset to support your temperament and individual skill sets. You need to pass the sleep-at-night test, with a sound investing process and compliment with the investor's temperament, psyche and skill sets. Then can only the investor sleep at night without the worry of short term changes in price of his stocks.

Prudent investing involves fundamental analysis of the business, sleep soundly at night and adopt a mix of investment philosophies to curtail his investment strategy. Prudent investing involves studying the business, the management and potential future growth story, study the financial statements and determine the intrinsic value of the business and have the right psychology. The crux of prudent investing is to buy businesses selling below its intrinsic value. It focus on fundamental analysis instead of using technical analysis. Prudent investing has no regards to price fluctuations and set a long time horizon to hold the stock of the business.

Risk

During the crisis in 1997, 2000 and 2007, a lot of Singaporeans lost their entire life savings in the stock market and they brand investing equivalent to gambling. Investing is not risky if you know what you are doing. It is just like driving, if you know the rules and has been on the road, you will know how to reduce the risk to minimum. You need to have the comprehension, courage and conviction of the business which you are going to acquire and will not deviate from your decision in trying times. In the academic finance literature, beta is a measure of volatility of a security. High beta equates to high risk but high beta presents better buying opportunity. For instance, ABC Company has intrinsic value of $25 but is trading at $20, this may seems attractive but if the stock drops further to $10, the stock is more volatile but will become a more attractive investment due to larger bargain.

Investment needs a business approach to evaluate the company. There is a business behind the stock price, business takes time to flourish and fundamentals do not change overnight, unlike a stock price. Business has its business cycle, it will achieve stellar growth during its infant stage and reaches a plateau slow growth in its mature stage. Stock price is not equivalent to the value of the business. In short term, the stock market is a voting machine and long term is a weighing machine. Price of the stock does not represent the value of the business in the short term. In the long term, both price and value will converge.

How prudent investing works

The share price of a company increase when investors expect stronger future earnings. Prudent investors look for future growth driver which will increase the share price of the stock. Future growth drivers of a company include expansion of business, increase in product varieties and innovating the products.

Rebalancing

Rebalancing is a powerful strategy

Rebalancing is the process of buying and selling to bring your portfolio back to your target allocation. Your portfolio's components will change overtime due to market forces, some will do better than others, those that done well will take up a higher percentage of the portfolio. You need to readjust to bring the portfolio back to the original balance. Rebalancing is about risk management to ensure that your portfolio is not dependent on a single asset class to succeed or fail. If your risk profile has change, then you need to revise your asset allocation according to risk appetite.

Rebalancing helps you to reap the full rewards from diversification, by scaling down on your winner, you will free up your resources and reposition them to your laggard. Rebalancing helps to remove the psychological factor of investor in the market cycle.

How to Do That?

Step 1 Set your target portfolio mix

Firstly, you need to determine all you asset classes and fix on the investment styles which will lead you to your investment goal. For instance, Jason has $100,000 to invest. He decides to invest 50% ($50,000) to stocks, 20% ($20,000) to bond, 10% ($10,000) to gold and remaining 20% ($20,000) to cash. This is the opening balance and he will like to remain in this portfolio mix.                          

Step 2 What is the difference?

Compare your target component to your present component. Then determine where your investments are not performing. Do you have a larger stake in a riskier company stock? Then consider your sector exposure, this is to ensure you will not have over exposure in particular industry. Then look at your investment to understand which one has performed the best. Continuing from previous example of Jason, at the end of the year, his stocks has grown to $75,000 , his bond has drop to $15,000 , gold has drop to $5,000 and cash remains the same. Total portfolio value is (75,000 + 15,000 + 5,000 + 20,000 = 115,000). The percent of stocks to his total portfolio values will be approximately 65%, bond to portfolio value will be 13%, gold will be 4% and cash will be 17%.

Step 3 Readjust

Then it is time to bring components of portfolio which has grown and direct the money to the investment which have not.

In this situation, Jason needs to sell his stocks and bring it back to 50%, so he need to sell to a level of approximate $57,500. This will bring some of his cash position to 20% which is $23,000 and the rest will be used to purchase additional bond and gold.

When do you need to rebalance?

You should conduct a thorough check on your portfolio once a year but only rebalance when it is not within your target. For example, you might rebalance when your allocation of stocks has exceeded 60% before you need to make changes. Hands off investors can set a higher limit by another 10% relative to their targets.

Costs of Rebalancing

During rebalancing, you need to cater for transaction costs to execute and process the trades, there will be commission, stock exchange fees, and taxes. For mutual funds, costs will include purchase or redemption fees. This will incur time on your side and if you engage a professional investment manager, you will incur administrative and management fees. If there is an increase in transactions, over the long run, it will affect your returns.

Strategies of Rebalancing

The portfolio can be rebalanced on a time-only strategy, it can be rebalanced daily, monthly or yearly basis. The second strategy will be on the limit of portfolio, you can predetermine rebalancing threshold such as 1%, 5% or 10%. The third strategy is to combine time and threshold. Rebalancing with dividends, interest payments, realized capital gains or new contributions can help investors exercise risk control and reduce the cost of rebalancing.

Conclusion

Rebalancing helps you to maintain your desired original asset allocation, allow you to fine tune according to your risk profile and remove emotions during investing.